Session 8

Exchange Rates
Disclaimer: The views expressed are those of the presenters and do not necessarily reflect those
of the Federal Reserve Bank of Dallas or the Federal Reserve System.
TEKS
(3) Economics. The student understands the reasons
for international trade and its importance to the
United States and the global economy. The student
is expected to:
(C) analyze the impact of U.S. imports and exports
on the United States and its trading partners.
(4) Economics. The student understands the issues of
free trade and the effects of trade barriers. The
student is expected to:
(C) analyze the effects of changes in exchange rates
on imports and exports.
Teaching the Terms
• Exchange rates
• Appreciate
• Depreciate
• Purchasing power parity
• Nominal values
• Real values
Foreign Exchange Market
• Derived demand
• Currencies are bought and sold
• Largest financial market in the world
• Operates 24 hours a day
Nominal Exchange Rates
• Rate at which the currency of one country can
be exchanged for the currency of another
country
• Depreciate = Weaken = Lose value
• Appreciate = Strengthen = Gain value
Exchange Rates
• One exchange rate is the reciprocal of another
exchange rate
– If €1 = $2.00, then $1 = €0.50
• As the exchange rate fluctuates, the value (or
strength) of each currency is affected
• When one currency strengthens, the other
weakens
Weakening Dollar / Strengthening Euro

Value of
•$1 = €1.00 (or €1 = $1.00)

U.S. dollar
•$1 = €0.67 (or €1 = $1.50)

Falling
•$1 = €0.50 (or €1 = $2.00)
Weakening Euro / Strengthening Dollar

Value of
•€1 = $2.00 ($1 = €0.50)

Euro
•€1 = $1.50 ($1 = €0.67)

Falling
•€1 = $1.00 ($1 = €1.00)
Exchange Rates in the Short Run
• Model with supply and demand graph
– Quantity of dollars
– Price of a dollar in a foreign currency
• Factors affecting supply of dollars
– American purchase of goods and services produced abroad
– American investment in foreign assets
• Factors affecting demand for dollars
– Foreign purchase of American goods and services
– Foreign investment in American assets
 S1

Number of Euros per Dollar

S2

1
2

D1

1 2
Quantity of Dollars Traded

Increasing supply of dollars

Leads to a falling price (value)

 S1

Number of Euros per Dollar

2
1

D2

D1

1 2
Quantity of Dollars Traded

Increasing demand for dollars

Leads to a rising price (value)

A stronger U.S. dollar means …

U.S. can buy foreign

goods more cheaply
and U.S. imports
will increase

Foreigners find U.S.

goods more
expensive and U.S.
exports fall
A weaker U.S. dollar means …

Foreigners can buy

American goods more
cheaply and U.S.
exports will increase

Foreigner goods
become more
expensive for U.S.
residents and U.S.
imports fall
Exchange Rates in the Long Run
• Law of one price
Identical items should sell for the same price
• Purchasing power parity (PPP)
One unit of domestic currency will buy the same
basket of goods anywhere in the world
• PPP implies that the real exchange rate will
always be 1
Exchange Rates in the Long Run
• Real exchange rate
Rate at which the goods and services of one
country can be exchanged for the goods and
services of another country
Dollar price of domestic goods

• Real exchange rate = Dollar price of foreign goods

Questions?